Financial Guarantee Insurance

Transcription

1 Board Meeting Handout Financial Guarantee Insurance November 21, At today s meeting, the Board will begin redeliberations of the Exposure Draft, Accounting for Financial Guarantee Insurance Contracts. The issues for redeliberation at this meeting are scope (one aspect), claim liability recognition and measurement, and premium revenue recognition. SCOPE Issue 1 Expansion of the Scope Background Information 2. In the Exposure Draft, paragraph 2 states that the proposed Statement applies to financial guarantee insurance (and reinsurance) contracts issued by insurance enterprises included within the scope of paragraph 6 of FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises. Paragraph 5 of the Exposure Draft clarifies that the scope of the proposed Statement does not apply to (a) financial guarantee insurance contracts issued by noninsurance enterprises (for example, some financial institutions and government-sponsored entities) and (b) insurance contracts that are similar to financial guarantee insurance contracts issued by insurance enterprises (for example, mortgage guaranty insurance and credit insurance on trade receivables). Finally, the Exposure Draft states that the guidance would not be applied or analogized to by enterprises not in its scope. 3. The issues addressed in the Exposure Draft arose from the application of the insurance accounting models in Statement 60 by insurance enterprises that issue financial guarantee insurance contracts. Accordingly, the Board decided to The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 limit the scope to insurance enterprises. The Board acknowledged that economically similar contracts that were not within the scope of the Exposure Draft would be accounted for differently. The Board made this decision because a scope expansion would delay issuance of needed guidance to resolve current practice issues relating to financial guarantee insurance contracts issued by insurance enterprises. The Board also restricted the application of this guidance by analogy because the Exposure Draft is an interpretation of accounting literature that only applies to insurance enterprises. Constituent Comments 4. Many of the respondents questioned the limited scope of the Exposure Draft because financial guarantee insurance contracts are economically similar to other types of financial guarantee contracts. These respondents commented that the proposed scope creates complexity, reduces comparability, and incorrectly focuses on the enterprise rather than the transaction. One respondent stated that accounting guidance should be provided for subsequent measurement and extinguishment issues related to FASB Interpretation No. 45, Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Questions for Board 5. Does the Board agree that the scope of the proposed Statement should apply to financial guarantee insurance (and reinsurance) contracts issued by insurance enterprises included within the scope of paragraph 6 of Statement 60? Further, does the Board agree that the scope should be limited and not apply to financial guarantee contracts issued by noninsurance enterprises or insurance contracts that are similar to financial guarantee insurance contracts issued by insurance enterprises? 2

3 CLAIM LIABILITY Issue 2 Recognition Threshold Background Information 6. In the Exposure Draft, the Board decided that an insurance enterprise should recognize a claim liability when there is an expectation that a claim loss on a financial guarantee insurance contract will exceed the unearned premium revenue (liability) for that contract based on expected cash flows. This decision was premised on the observation that the unearned premium revenue (liability) represents the insurance enterprise s stand-ready obligation, at initial recognition, under the financial guarantee insurance contract. Consequently, the Board concluded that the liability for unearned premium revenue at inception of the financial guarantee insurance contract establishes a threshold for claim liability recognition in subsequent periods. Constituent Comments 7. Many of the respondents disagreed with the proposed claim liability recognition threshold. These respondents stated that a claim liability should be recognized immediately once a deteriorating credit situation is identified, not when the expected cash flows from a claim loss exceed the unearned premium revenue (liability). Further, they pointed out that the recognition threshold used in the Exposure Draft delays claim liability recognition and reduces the usefulness of the financial statements. These respondents supported reporting the claim liability and the unearned premium revenue (liability) independently (that is, mutually exclusive of one another). Question for Board 8. Does the Board agree that an insurance enterprise should recognize a claim liability on a financial guarantee insurance contract when the insurance enterprise expects that a claim loss will exceed the unearned premium revenue (liability) for that contract based on expected cash flows? 3

4 Issue 3 Discount Rate Used to Measure Claim Liability Background Information 9. In the Exposure Draft, the Board decided that an insurance enterprise would measure a claim liability based on the present value of expected cash flows discounted using a risk-adjusted rate at initial recognition of the claim liability. The risk-adjusted rate represents the risk-free rate, adjusted for the credit standing of the insurance enterprise. The Board concluded that the claim liability is an obligation of the insurance enterprise and that the discount rate should reflect the ability of the insurance enterprise to make the expected claim payments. 10. In subsequent periods, the measurement of the expected cash flows should be updated for changes in the likelihood of default. However, those changes to the claim liability should continue to be measured using the same discount rate used at initial recognition of the claim liability so that the measurement is not affected by general changes in interest rates. 11. The Board concluded that the discount rate used in measuring the claim liability should be updated only upon the event of default. The Board observed that a default is a significant event that changes the nature of the insurance enterprise s obligation. Accordingly, the measurement of the claim liability at the time of default should incorporate current information about general interest rates and the insurance enterprise s credit standing. Constituent Comments 12. Many of the respondents disagreed with measuring a claim liability using a discount rate based on the insurance enterprise s credit standing because it creates a lack of comparability among insurance enterprises. These respondents pointed out that if two insurance enterprises with different credit standings measured the same claim liability, the insurance enterprise with the lower credit standing would recognize a lower claim liability than the insurance enterprise with a higher credit standing. 4

5 13. Several respondents stated that if the Board s intention was to eliminate the effects of changes in general interest rates within the measurement of the claim liability, the discount rate used should be determined at inception of the financial guarantee insurance contract and should not be updated upon default. One respondent pointed out that under the provisions of the Exposure Draft, a claim liability might be recognized simply because of a change in interest rates. Questions for Board 14. Does the Board agree that the measurement of a claim liability based on the present value of expected cash flows should be discounted using a riskadjusted rate (adjusted for the credit standing of the insurance enterprise) at initial recognition of the claim liability? If so, does the Board agree that the discount rate should be set at initial recognition of the claim liability and updated only when a default has occurred? PREMIUM REVENUE RECOGNITION Issue 4 Scope Background Information 15. The financial guarantee insurance contracts project arose from diversity in practice related to claim recognition and measurement for financial guarantee insurance contracts issued by insurance enterprises. In addressing the diversity in practice, the Board concluded that providing guidance for only claim liability recognition and measurement represented one part of a financial guarantee insurance contract. The Board observed that providing guidance for only one part of a financial guarantee insurance contract was problematic; both insurance accounting and fair value measurement view a contract as a whole and providing guidance for one piece of the insurance contract would not reflect the interrelationship between cash flows (premiums and claims). Consequently, the Board concluded that premium revenue recognition should be addressed as well. 5

6 Constituent Comments 16. Respondents to the Exposure Draft stated that the premium revenue recognition approach used in practice appropriately reflects the passage of time and, unlike the claim recognition and measurement approaches used in practice, there is no diversity. Some of these respondents observed that the premium revenue recognition approach used in practice reflects the nature of a financial guarantee insurance contract that is, premium revenue recognition is frontloaded because the risk of default is higher at the beginning of a financial guarantee insurance contract. However, at the September 4, 2007 roundtable, one participant explained that the risk of default is backloaded because insurance enterprises insure investment grade financial obligations, such as senior tranches of asset-backed securities, with high attachment points and overcollateralization. 17. The staff solicited feedback from users of the financial statements through the comment letter process, roundtable participation, and the Investors Technical Advisory Committee. The majority of users did not agree with the proposed premium revenue recognition approach. However, their reasons varied. Some users agreed with the preparers that the proposed premium revenue recognition approach did not reflect the passage of time or the economics of a financial guarantee insurance contract. Other users stated that the premium revenue recognition approach used in practice was understandable and, through non- GAAP disclosures, they were able to obtain the cash flow information necessary for their analysis. Still, other users stated that they supported measuring financial guarantee insurance contracts at fair value and any change that was not a fair value measurement would not be useful to them. In addition, these users observed that the IASB insurance contracts project would result in another change in a relatively short period of time, further complicating their analyses. Question for Board 18. Does the Board believe that premium revenue recognition guidance should be provided for financial guarantee insurance contracts? 6

7 Issue 5 Proposed Premium Revenue Recognition Approach Background Information 19. The Board decided to provide premium revenue recognition guidance for financial guarantee insurance contracts in the context of a Statement 60 shortduration contract accounting model. This model links premium revenue recognition to the amount of insurance protection provided. The Exposure Draft requires that premium revenue be recognized over the period of the contract in proportion to the insured contractual payments made by the issuer of the insured financial obligation. The premium revenue recognition approach links premium revenue recognition to the insured contractual payments made by the issuer of the insured financial obligation. The insurance enterprise is obligated to assume any remaining insured contractual payments to be made by the issuer of the insured financial obligation in the event of default. The underlying presumption is that the risk to the insurance enterprise is reduced to the extent of the insured contractual payments made by the issuer of the insured financial obligation. Accordingly, once an insured contractual payment is made by the issuer of the insured financial obligation, revenue is recognized. 20. The Board acknowledged that in instances in which principal is not paid until maturity, such as an insured zero-coupon bond, the proposed premium revenue recognition approach may not appropriately reflect the reduction of risk associated with the insured financial obligation due to the passage of time. In addressing this issue, the Board considered an alternative approach (the industry-proposed level-yield approach) but ultimately decided that the levelyield approach may not reflect the economic risk of the financial guarantee insurance contract. Consistent with its view that the premium revenue recognition approach should be consistently applied across all financial guarantee insurance contracts, the Board did not modify the approach. 7

8 Constituent Comments 21. The majority of respondents disagreed with the proposed approach to premium revenue recognition stating that it (a) did not incorporate the passage of time, (b) was inconsistent with Statement 60, and (c) did not reflect the economic reality of a financial guarantee insurance contract. One respondent stated that premium revenue recognition should be based on the service provided to the policyholder since the beneficiary of the financial guarantee insurance contract is protected from economic loss throughout the term of the financial guarantee insurance contract. That respondent observed that an insurance enterprise should recognize revenue as this protection is being provided. Several respondents offered alternative approaches to premium revenue recognition. Questions for Board 22. Does the Board agree that an insurance enterprise should recognize premium from a financial guarantee insurance contract as revenue over the period of the contract in proportion to the insured contractual payments made by the issuer of the insured financial obligation? If not, what premium revenue recognition approach should be applied to financial guarantee insurance contracts? Issue 6 Contractual Term versus Expected Term Background Information 23. The Exposure Draft defines the term of a financial guarantee insurance contract as the contractual term of the insured financial obligation. It requires that premium revenue be recognized over the period of the contract. The Board acknowledged that when an insured financial obligation is subject to prepayments, the exposure period may be shorter than the contractual period. However, the Board concluded that in the absence of observable data about prepayment expectations, it would be difficult to reliably assess the likelihood of prepayment. Consequently, due to the significant discussion surrounding this topic, the Board asked the staff to include a question in the Notice to Recipients 8

9 asking for information on the ability to observe and reliably estimate prepayments. Constituent Comments 24. A majority of respondents disagreed with using the contractual term as the period over which to recognize premium revenue. These respondents stated that (a) prepayment data are used in the pricing of financial guarantee insurance contracts, (b) prepayment data are readily available and can be reliably estimated, (c) not considering prepayments is inconsistent with FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, and (d) using the contractual term reduces the usefulness of the financial statements. Questions for Board 25. Does the Board agree that, for premium revenue recognition, the term of a financial guarantee insurance contract is the contractual term of the insured financial obligation? If not, should the term of a financial guarantee insurance contract reflect expected prepayments? If prepayment data are used to determine the expected term, what should be the unit of account? Issue 7 Insured Contractual Payments Background Information 26. (Note: This issue is only relevant if the premium revenue recognition approach incorporates exposure. For example, both the proposed premium revenue recognition approach in the Exposure Draft and the level-yield approach use exposure as a component in recognizing premium revenue. On the other hand, a straight-line approach would not use exposure to determine premium revenue recognition.) 27. The Exposure Draft requires that premium revenue for each reporting period would be determined based on the ratio of (a) the insured contractual payments made during the period to (b) the total of all insured contractual 9

10 payments to be made over the period of the contract. The Exposure Draft defines insured contractual payments as principal and interest payments. The Board observed that the insurance enterprise is at risk to the extent of the insured contractual payments that have not yet been made by the issuer of the insured financial obligation. In the event of default, the insurance enterprise assumes the obligation to make those remaining payments. Accordingly, the Board concluded that the best measure of the reduction of risk associated with the insured financial obligation are principal and interest payments. Constituent Comments 28. Most respondents disagreed that principal and interest payments are a better measure of the risk associated with an insured financial obligation. These respondents preferred using the principal payments (only) stating that it represented a present value of the insured financial obligation and is more consistent with the proposed claim recognition approach in that it incorporates discounted amounts. These respondents also pointed out that at the time of default, the insurance enterprise has the option to either continue making principal and interest payments or to pay the principal outstanding plus any accrued interest. Questions for Board 29. Does the Board agree that exposure should be defined as both principal and interest payments? If not, how should the exposure for a financial guarantee insurance contract be measured? 10

11 Board Meeting Handout Conceptual Framework November 21, 2007 At today s meeting, the Board will discuss three topics related to the measurement phase (Phase C) of the conceptual framework project. Topic I: Milestone I Summary Report Topic II: Plan Revisions Topic III: Preview of Measurement Basis Decision Tool TOPIC I: MILESTONE I SUMMARY REPORT The purpose of sharing the Milestone I Summary Report is to provide a review of the Boards deliberations of measurement issues and tentative decisions in the first stage of the measurement phase of the conceptual framework project. At meetings held in September and October 2007, Board advisors for the measurement phase suggested that the Boards would benefit from such a review, as most Board members continue to discuss measurement bases primarily in terms of historic cost and fair value rather than the terms that were agreed to in Milestone I. As deliberations progress in Milestones II and III, a clear use of terminology will become increasingly important. The report was prepared primarily for the information of constituents and has been posted to the Boards website. Thus, it reviews the purpose of the conceptual framework project and the plan for the measurement phase before summarizing Milestone I deliberations. With those enhancements, the report is intended to serve as a reference for those who may not have closely followed earlier measurement phase deliberations. Nevertheless, the staff thinks it is suitable as a review for the Board as well. TOPIC II: PLAN REVISIONS Background The staff prepares meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

12 The staff s original plan for Milestone II of the measurement phase called for a series of Board papers, one for each criterion that the Boards agreed to use to evaluate the measurement basis candidates. Each of those papers would have included a conceptual discussion of a criterion (such as relevance) and an evaluation of the basis candidates in light of that conceptual discussion. At the end of Milestone II, the staff planned to produce a summary evaluation of the basis candidates, including a tabular display that could be used as a tool by the Boards in Milestone III deliberations. Revised Plan The revised plan focuses on a decision tool that will do more than summarize evaluations of basis candidates. That decision tool will be in the form of a matrix that can be used for both evaluating and ranking the basis candidates in different contexts, such as choosing an ideal basis for the conceptual framework, using a mixture of bases in financial statements, and setting a standard with respect to a particular asset or liability. The staff is currently developing the decision tool (a preview follows under Topic III). When the decision tool and supporting material is complete, the staff will present it to the Boards as a package. Milestone III The revised plan eliminates or defers several issues that were originally included in Milestone III: The comparison and possibly ranking of the basis candidates subsequent to the summary evaluation of the candidates at the end of Milestone II is effectively collapsed into the decision tool, which can be used to both evaluate and rank the basis candidates. Issues related to the practical implementation of measurement bases are eliminated from the measurement phase because they are now viewed as questions that the Boards should consider, in particular standard-setting projects rather than in the converged framework. Research regarding whether the same basis or bases used for financial statements also should be used for other aspects of financial reporting is deferred to the presentation and disclosure phase (Phase E) of the conceptual framework project. 2

13 Whether one measurement basis should be used for all financial statement purposes or whether different bases should be used for different purposes will be addressed in the Board package. After that package has been deliberated by the Board, the staff will ask the Board whether further discussion is needed. Overall Effect The overall effect of the proposed changes to the plan may be summarized as follows: The original planned summary for Milestone II is enhanced as a decision tool that becomes the centerpiece of Milestone II, and the separate Board papers that were originally planned to lead up to the summary become support for the decision tool and the paper in which it is presented. Much of Milestone III is cut from the measurement phase and the rest is merged with the Milestone II decision tool and summary. Revised Timetable A revised timetable for the measurement phase, through the publication of a preliminary views document, follows. The revision brings forward the projected time of completion of a preliminary views document from the first half of 2009 to the fourth quarter of The earlier date assumes that additional staff will not be needed to produce a Board package in the indicated timeframe and that Board meetings beyond those shown below will not be needed for Board members to digest the package and achieve the objectives of the measurement phase. Those assumptions could prove false, in which case the timetable would have to be extended. 3

14 Date November 2007 February 2008 March 2008 April 2008 June 2008 July, August 2008 September, October 2008 November/December 2008 Meeting Topic or Preliminary Views Document Stage Review of Milestone I Revised plan for measurement phase Preview of measurement basis decision tool Measurement basis decision tool and evaluation summary package Issues remaining or arising from February meeting that can be turned around quickly Remaining issues from February meeting Issue M13: One basis for all purposes or different bases for different purposes? Staff drafting of preliminary views document Pre-ballot draft through post-ballot draft Publication of preliminary views document TOPIC III: PREVIEW OF MEASUREMENT BASIS DECISION TOOL Background In September and October 2007, the staff met with IASB and FASB Board advisors and discussed a tool to help the Boards make decisions about measurement basis candidates. This tool is a matrix that helps the decision maker to rank the candidates in a particular context with respect to specified decision criteria. The Decision Tool and Its Objective The diagram on the following page illustrates the process of building a decision tool and then placing the tool in a particular context for making a decision. As illustrated, building the tool requires the decision maker to identify a decision objective. The objective of making decisions about measurement basis candidates is the same as the objective of general purpose external financial reporting of an entity (that is, to provide decision-useful information to providers of the entity s capital). 4

15 Decision Process (Measurement Basis Decision Process) Decision Alternatives (measurement basis candidates) Decision Objective (objective of financial reporting) Decision Criteria (qualitative characteristics) Decision Tool (measurement basis decision tool) Decision Context 1 (identifying an ideal measurement basis) Decision Context 2 (ranking surrogates to the ideal basis) Decision Context 3 (selecting a basis for a particular standard) Unspecified decision criteria (Measurement assumptions, traditions, preconceived notions, etc.) Decision 1 (basis x) Decision 2 (ranked bases) Decision 3 (basis x or bases x,y,z) 5

16 Staff Recommendation The staff intends to discuss all nine of the measurement basis candidates (at least to some extent) in the Boards package next February. However, the staff suggests focusing on the following five candidates: Past entry price Modified past amount Current entry price Current exit price Value in use. The Decision Criteria After identifying the candidates, it is necessary to specify the criteria by which those candidates will be evaluated. The staff acknowledges that each Board member brings to the table certain unspecified decision criteria which may be based on underlying personal values, experiences, assumptions, preconceived notions, traditions, and other factors. These unspecified criteria are depicted in the diagram above to show that they may influence the Boards measurement decisions regardless of the context and the specified decision criteria. The decision tool requires the input of specified decision criteria. The Boards have agreed that these specified criteria should include the qualitative characteristics of financial reporting information, which are as follows: Relevance Faithful representation Verifiability Comparability Understandability Timeliness. 6

17 Staff Recommendation The staff recommends that the qualitative characteristics listed above should be used in the application of the decision tool. Question for the Board Should the staff include any other specified criteria in the decision tool? If so, what should these criteria be and why should they be included? The Decision Context Once the decision tool is built, then the decision maker must place it within a particular context for making a decision. The staff foresees the tool being useful in the following three decision contexts, which will be considered for the February package for the Boards: Identifying a conceptually ideal measurement basis Ranking surrogates for the conceptually ideal measurement basis Selecting a basis for a particular standard. An Example To demonstrate how the tool works, assume that candidates A, B, C, D, and E are being evaluated based on the objective and qualitative characteristics of financial reporting information. The context is ranking candidates to use within mixed-basis financial statements because the conceptually ideal measurement basis has practical limitations. Based on these assumptions, the decision maker ranks the alternatives by ordering measurement basis candidates A through E on a scale of five to one with five representing the highest (best) position and one representing the lowest (worst) position relative to that particular criterion. As an example, the decision maker considers candidate A to be the most relevant alternative to the objective of financial reporting information in the stated context and therefore assigns it a five. On the other hand, candidate E is considered the least relevant to the decision objective and is assigned a one. After ranking each alternative for all six specified criteria, the decision tool calculates a total score and indicates a final rank. 7

18 The measurement basis candidates A through E and their rankings relative to the decision criteria are purely arbitrary in this example. That is, this example is illustrative only and should not be construed to have any reference to the measurement basis candidates from Milestone I that will actually be considered. This table illustrates the tool s outcome based on the hypothetical candidates and rankings: Measurement Basis Candidates Relevance Faithful representation Verifiability Comparability Understandability Timeliness Total Score Final Rank Candidate A Candidate B Candidate C Candidate D Candidate E As seen above, candidate A received the highest total score and best final ranking. These results assume that the decision maker considers the decision criteria to be equal in their weighting on the decision and hence, each criterion is implicitly assigned a weighting factor of one. However, a decision maker may consider criteria such as relevance and faithful representation (primary qualitative characteristics) to be twice as important as another criterion such as comparability (an enhancing characteristic). In that case, all the rankings under the relevance and faithful representation columns would be multiplied by two in determining the final score. To further illustrate the effect of changing the weighting factors, assume that the decision maker s rankings are exactly the same as they are above. However, the weighting of three criteria is changed as follows: relevance and faithful representation are changed to a factor of 8

19 two because they are considered primary characteristics of financial reporting information. Verifiability is then changed to one and a half because it is considered more important than comparability, understandability, and timeliness but not as important as relevance and faithful representation. These weightings serve merely as an example of how a decision maker in a specific context may change the weighting factor of one decision criterion relative to others. Based on these different weighting factors (and all else being equal), the total score and final ranking of the candidates change as follows: Decision weighting factor of each criterion Measurement Basis Candidates Relevance Faithful representation Verifiability Comparability Understandability Timeliness Total Score Final Rank Candidate A Candidate B Candidate C Candidate D Candidate E This example demonstrates how the decision tool can be used in a specific context. The example also shows how changing the weighting factors of the decision criteria can significantly change the tool s outcome and ultimately, the decision. The February package will further discuss how the decision criteria are sensitive to and interpreted within a particular context. 9